The best U.S. banks to invest in
The post-crisis financial landscape may be confusing, but it offers more banking models to choose from -- including one that seems poised for long-term growth.
If you were designing a bank now, from scratch, for growth and maximum profits, what kind of bank would you build?
Bank earnings in the U.S. this year -- from the biggest and most aggressive investment banks such as Goldman Sachs (GS.N) to the do-everything behemoths such as JPMorgan Chase (JPM.N), to the lending-oriented banks such as U.S. Bancorp (USB.N), to the specialist banks -- don't give a single definitive answer. It's hard to tell whether the old models are in need of serious overhaul or just taking a breather, and there are serious doubts about the future profitability of many classic banking activities.
And I think that's healthy -- even if it makes life hard for investors. The clear consensus on what a bank should be if it wanted to maximize growth and profits was, it turns out, one of the great weaknesses of the banking system before the financial crisis. Too many banks had decided to be the same kind of bank. And that left the industry exceedingly vulnerable to disruption and failure.
For the moment, at least, investors are free again to look for the best bank among many styles of banks, rather than investigating which bank matches up best with a single model for success.
Here's how the landscape looks to me right now and the names of some interesting banks, of different models.
Before the financial crisis, bank CEOs thought they had a clear answer to what the best bank would be like. They wouldn't worry too much about building a big base of depositors; in the financial markets it was easy to raise all the money a bank needed to finance its lending and other activities. They'd build trading desks that traded for clients, of course, but that also put the bank's own capital at risk in proprietary trades. And they'd work to build up investment banking activities ranging from underwriting stock and bond offerings to selling packages of securitized mortgages, credit card receipts and car loans. They would also engage in complex derivatives that let clients bet on the direction of financial markets or let them hedge the risk of complicated trading strategies.
The bank these CEOs had in mind was about as far from Frank Capra's Bailey Building & Loan as possible.
But the financial crisis took some of the edge off that model.
For one thing, it demonstrated that the banks built on that model had put everything in one basket. They needed functioning financial markets not just to raise capital but also to roll over the existing debt that provided current capital. Gains from trading for a bank's own account were dependent on being able to figure out the direction of the markets, and revenue from trading for clients' accounts were dependent on the willingness of those clients to be in the markets at all.
The model left banks with strikingly few alternatives in a crisis. At the end of "It's a Wonderful Life," the building and loan's depositors ride to George Bailey's rescue. In the recent crisis, banks built around the pre-crash model had no one to turn to but governments and reluctant taxpayers.
Here's a quick rundown of the various banking models and their prospects:
The investment bank/trading model: Not dead yet
It's not clear how damaged this model is. In the first quarter of 2010, it looked like it was back on top: Trading and investment banking revenue soared while commercial and consumer lenders were still drowning in a sea of bad loans. In the just-completed second quarter, trading and investment banking revenue fell. The infallible traders of the first quarter turned out to be no better than the average investor at making a profit in a volatile and unpredictable market. Even the banks, such as Morgan Stanley (MS.N), that had looked like they'd had successful trading quarters wound up making a good part of their trading revenue out of accounting gimmicks based on the price of their own debt.
But the biggest long-term threat to the trading and investment banking model as adopted by U.S. banks comes from the shift in global finance toward the world's developing financial markets. The largest stock offerings of 2010, for example, haven't been in New York or London but in São Paulo, Hong Kong and Shanghai. The big U.S.-based pre-crisis powers such as Morgan Stanley haven't been shut out of these deals, but they've had to share them with "local" banks such as HSBC (HBC.N) in Hong Kong and Itaú Unibanco (ITUB.O) in São Paulo. In one example of growing heft, Itaú climbed past Goldman Sachs in 2009 to become the fourth-largest underwriter of overseas bond sales for Brazilian companies.
This global shift in what I'd call not financial power but financial weight puts the big U.S. banks that had adopted the investment banking/trading model at a disadvantage in two more ways:
* First, as a result of the financial crisis, many of the U.S. banks that had built up the biggest overseas networks of offices and contacts either sold off those units or scaled them back.
* Second, many of the U.S. banks built on the investment banking/trading model now can't match the deposit-gathering power of either big (Banco Santander (STD.N) and HSBC) or smaller (India's HDFC (HDB.N)) overseas banks.
Once the banks built on the investment bank/trading model have their bounce -- and some of them clearly have -- investors need to recognize that the U.S. banks that adopted this model face some of the toughest challenges in the banking sector. Indeed, my favourite banks built on this model are not U.S. banks. I much prefer overseas banks such as Itaú Unibanco, HSBC and Banco Santander.
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